Despite Market's Moodiness, IPO Pipeline Is Swelling

The volatility in the stock market has spilled over into recent IPOs, making performance tough to predict. VMware (NYSE: - ) lived up to its hype when it jumped 75% in its Aug. 13 debut. But two days later Cosan (NYSE: - ), a Brazilian ethanol producer that some had expected good things from, opened flat.

Despite the uncertainties, Ernst & Young's recent U.S. IPO Pipeline report saw plenty to look forward to. The average deal size confirms the recent trend of bigger IPOs, with medicine, technology and energy providing the largest share of deals.

Maria Pinelli, the Americas director of the firm's strategic growth markets division, recently spoke with IBD about the keys to IPO-watching in an uncertain market.

IBD: Do you have any expectations or forecasts for what's going to happen next on the IPO market?

Pinelli: That's a difficult one. We'll just have to sit tight and wait and see.

I can tell you that we're watching the indicators very closely, and one of the ways in which we monitor that is what our pipeline looks like. In our June 30 report, it looks pretty good. Ninety-seven companies filed at (a total value of) $18 billion. There were three strong sectors: technology, biotech, and oil and gas.

It's showing an average IPO value of over $200 million. That's pretty significant -- it's up from 2006, where the average was $180 million. So not only for the first half of the year are we seeing the average IPO value significantly higher, but we're having a more robust pipeline.

As of Aug. 15, there were 115 IPOs in the pipeline (valued at) $22 billion. Again, there are the three key sectors. So if we can maintain investor confidence the pipeline looks very strong, and the industries coming to market appear to be industries that have been traditionally financed by the capital markets.

IBD: I noticed in the June 30 report you highlighted the upcoming IPOs of VMware and Cosan. It was interesting how it turned out -- VMware did very well, Cosan not so well. Do you take anything from that?

Pinelli: A couple things. One is that this is not the IPO market of the Internet exuberance that we saw a few years ago. It's a very measured market; it's rewarding companies on strong financial indicators, solid business models, sales growth, profitability, strong management teams.

Honestly, this is our message time and time again. There is a robust amount of capital available in the U.S. and globally through the capital markets, and there's a huge amount of private capital available. The scrutiny and the competition for investor funds continues. Some of these companies have done really well and they've been preparing a long time for this event, have built up the infrastructure over several years. Timing the market is really just one small factor. Being prepared, (having) the ability to meet your forecasts and deliver on your promises to the investor community is really paramount.

IBD: The market in the last couple weeks has been very volatile. Do you have a different way of approaching IPOs in a market like this?

Pinelli: We work with companies on a regular basis that are planning an offering. In fact, we hold a pretty exclusive conference around this event, where CEOs and their teams are educated on this entire process.

(What's important is) real transparency. What is actually happening in the business? Because often we see situations where there is volatility in the market, but the business itself continues to operate and meet its forecast. I'm thinking of last February when there was a rumor in the Asian markets that caused some volatility in the marketplace. But when you actually looked at company performance in individual investments, the question is, "Are these companies on track for their original plan?"

Where it becomes sensitive is when there are other economic indicators that are affecting the forecasting or the original business plan estimates of a company. Transparency on that is so paramount. One of the struggles we often see in this preparation to become a public company is the amount of rigor that's required over the financial planning and analysis of the business. It's a cultural change. Typically an IPO company is poised for growth -- they've got an entrepreneurial spirit, they're fast-moving. Trying to instill this rigor of accountability, planning, forecasting, ability to actually deliver on your promises -- that does create tension.

First and foremost make sure you've got the right balance in your business between encouraging growth and managing risk. When that is out of balance, not only does the organization itself (get) placed under stress, but you can lose key employees. You've got people who are entrepreneurial and innovative, and then you're trying to build structure. There's a clash. As an investor, you have to be aware of (that).

IBD: Companies seem to go public in different phases of the process though. You see a lot of prospectuses that say things like, "We've identified a material weakness in our internal controls, and we're taking measures," but they haven't actually finished fixing it. Do you think a company should have all that done before going public?

Pinelli: If you want to be successful as a public company, that function has to be up and running. I mean, really. There's just so much accountability to investors and the public at large. And also, you want to build a strong employee base that understands each part of the culture of the overall business. You can't afford to be adjusting your internal culture when you're in the public markets and have the demands. You have customer demands, you have employee demands -- and now you have a whole new constituency, an investor group.

IBD: Recently private equity has been a major factor in the IPO market, both in bringing out new IPOs and in buying potential IPOs off the market. Do you see that continuing to have an impact?

Pinelli: We think it will continue to have an important impact. Certainly last year we saw a significant impact. As private equity continues to make investments in companies to help them fuel their growth, they'll be looking to next stages of growth or possibly exits. The capital markets are certainly an option.